Inventories buildup cited; analyst prefers Eli Lilly

SusanLerner

Merck
MRK, +1.81%
a component of the Dow Jones Industrial Average
DJIA, +0.34%
fell 44 cents, or 1.3%, to close at $33.01.

"Merck's recent gross margin trends may be overstated based upon our analysis of the company's accounting for long-term inventory," analyst Catherine Arnold said in reiterating her underperform rating on the shares.

"These practices are unlikely to be sustainable, may lead to future charges and may add risk to upcoming gross margin performance," she said in a note to clients.

Arnold based her assessment on the company's recent 10-K and 10-Q filings, which she said show the company has been building a substantial balance of "long-term inventory," having purchased or produced more than $700 million of pre-launch vaccine components, stocks of Arcoxia, marketed vaccines and other products that it expects to sell more than one year out from the current period.

Although this is in accordance with U.S. generally accepted accounting principles, Arnold called the inventories "unusual" and said they distort the company's gross margin and financial ratios.

Without the buildup of long-term inventory, Arnold estimates that Merck's gross margin could have been 80 to 460 basis points lower in the third quarter of 2004 compared to the first quarter of 2005.

"We suspect the build of long-term inventory may have contributed to Merck's ability to report surprisingly strong gross margins during a time at which there was much investor focus on this issue," Arnold said.

Because inventory and cost of goods are fundamentally related and zero-sum, she said the buildup of long-term inventory will have an impact future gross margins: "We anticipate that Merck may either be forced to write a portion of them off or report lower gross margins from unabsorbed overhead in future years."

Meanwhile, concerns about the company's inventory position are compounded by the belief that current market expectations don't adequately discount the future deleveraging impacts of product losses through 2008, which would be the equivalent of $9 billion, or 39%, of 2004 sales.

As sales of high-profile drugs like Vioxx, Zocor and Fosamax decline, Arnold expects that revenue will decline at an average annual pace of 2% and that it will take Merck three to five years to completely restructure its manufacturing capacity.

"With the successive losses of these products, we forecast Merck's gross margin will contract, from 81% in 2003 before the withdrawal of Vioxx, to 72% in 2009 after the loss of Vioxx, Zocor and Fosamax," she said.

Considering her belief that the company's growth outlook is worse than projected by the market and taking into account "the overhang of Vioxx and management uncertainty," Arnold recommends selling Merck shares and making a switch into Eli Lilly & Co.
LLY, +0.83%
instead.

Lilly, on Tuesday, reported positive Phase II clinical trial results that indicated patients with a form of brain cancer experienced a significant response, with minimal side effects, when treated with the company's oral Enzastaurin agent.

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